ISA 545 - Auditing Fair Value Measurements and Disclosure

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INTERNATIONAL STANDARD ON AUDITING

(UK AND IRELAND) 545
AUDITING FAIR VALUE MEASUREMENTS AND
DISCLOSURES
CONTENTS
Paragraph
Introduction............................................................................................ 1 - 9
Understanding the Entitys Process for Determining Fair Value
Measurements and Disclosures and Relevant Control Activities, and
Assessing Risk....................................................................................... 10 - 16
Evaluating the Appropriateness of Fair Value Measurements
and Disclosures...................................................................................... 17 - 28
Using the Work of an Expert ................................................................. 29 - 32
Audit Procedures Responsive to the Risk of Material Misstatement of the
Entitys Fair Value Measurements and Disclosures .............................. 33 - 55
Disclosures About Fair Values .............................................................. 56 - 60
Evaluating the Results of Audit Procedures .......................................... 61 - 62
Management Representations ................................................................ 63 - 64
Communication with Those Charged with Governance ........................ 65
Effective Date ................................................................................... 66
Appendix: Fair Value Measurements and Disclosures under Different
Financial Reporting Frameworks

International Standard on Auditing (UK and Ireland) (ISA (UK and Ireland))
545 Auditing Fair Value Measurements and Disclosures should be read in
the context of the Auditing Practices Boards Statement The Auditing
Practices Board - Scope and Authority of Pronouncements (Revised) which
sets out the application and authority of ISAs (UK and Ireland).
ISA (UK and Ireland) 545
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Introduction
1. The purpose of this International Standard on Auditing (UK and Ireland)
(ISA (UK and Ireland)) is to establish standards and provide guidance on
auditing fair value measurements and disclosures contained in financial
statements. In particular, this ISA (UK and Ireland) addresses audit
considerations relating to the measurement, presentation and disclosure of
material assets, liabilities and specific components of equity presented or
disclosed at fair value in financial statements. Fair value measurements of
assets, liabilities and components of equity may arise from both the initial
recording of transactions and later changes in value. Changes in fair value
measurements that occur over time may be treated in different ways under
different financial reporting frameworks. For example, some financial
reporting frameworks may require that such changes be reflected directly in
equity, while others may require them to be reflected in income.
1-1. Many of the examples of accounting principles given in this ISA (UK and
Ireland) are based on International Accounting Standards. If other
accounting standards are used (e.g. Financial Reporting Standards issued by
the UK Accounting Standards Board) the auditor recognizes that, whilst the
accounting principles may differ, the audit principles remain the same.
1-2. Paragraph 22 of ISA (UK and Ireland) 315 Understanding the Entity and
its Environment and Assessing the Risks of Material Misstatement
requires that the auditor should obtain an understanding of the
applicable financial reporting framework. That understanding includes the
requirements of the particular accounting standards that the entity is
required or chooses, where a choice is possible, to comply with. The
auditor takes that understanding into account when complying with the
requirements of this ISA (UK and Ireland). The auditor also takes into
account requirements of legislation pertaining to fair value accounting (e.g.
Schedule 4 of the UK Companies Act 1985 as amended by The Companies
Act 1985 (International Accounting Standards and Other Accounting
Amendments) Regulations 2004).
1-3. This ISA (UK and Ireland) uses the terms those charged with governance
and management. The term governance describes the role of persons
entrusted with the supervision, control and direction of an entity.
Ordinarily, those charged with governance are accountable for ensuring that
the entity achieves its objectives, and for the quality of its financial
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reporting and reporting to interested parties. Those charged with
governance include management only when they perform such functions.
1-4. In the UK and Ireland, those charged with governance include the directors
(executive and non-executive) of a company or other body, the members of
an audit committee where one exists, the partners, proprietors, committee of
management or trustees of other forms of entity, or equivalent persons
responsible for directing the entitys affairs and preparing its financial
statements.
1-5. Management comprises those persons who perform senior managerial
functions.
1-6. In the UK and Ireland, depending on the nature and circumstances of the
entity, management may include some or all of those charged with
governance (e.g. executive directors). Management will not normally
include non-executive directors.
2. While this ISA (UK and Ireland) provides guidance on auditing fair value
measurements and disclosures, audit evidence obtained from other audit
procedures also may provide audit evidence relevant to the measurement
and disclosure of fair values. For example, inspection procedures to verify
existence of an asset measured at fair value also may provide relevant audit
evidence about its valuation (such as the physical condition of an
investment property).
2a. ISA (UK and Ireland) 500, Audit Evidence paragraph 16 requires the
auditor to use assertions in sufficient detail to form a basis for the
assessment of risks of material misstatements and the design and
performance of further audit procedures in response to the assessed risks.
Fair value measurements and disclosures are not in themselves assertions,
but may be relevant to specific assertions, depending on the applicable
financial reporting framework.
3. The auditor should obtain sufficient appropriate audit evidence that
fair value measurements and disclosures are in accordance with the
entitys applicable financial reporting framework. Paragraph 22 of ISA
(UK and Ireland) 315, Understanding the Entity and Its Environment and
Assessing the Risks of Material Misstatement requires the auditor to
obtain an understanding of the entitys applicable financial reporting
framework.
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4. Management
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is responsible for making the fair value measurements and
disclosures included in the financial statements. As part of fulfilling its
responsibility, management needs to establish an accounting and financial
reporting process for determining the fair value measurements and
disclosures, select appropriate valuation methods, identify and adequately
support any significant assumptions used, prepare the valuation and ensure
that the presentation and disclosure of the fair value measurements are in
accordance with the entitys applicable financial reporting framework.
5. Many measurements based on estimates, including fair value
measurements, are inherently imprecise. In the case of fair value
measurements, particularly those that do not involve contractual cash flows
or for which market information is not available when making the estimate,
fair value estimates often involve uncertainty in both the amount and timing
of future cash flows. Fair value measurements also may be based on
assumptions about future conditions, transactions or events whose outcome
is uncertain and will therefore be subject to change over time. The auditors
consideration of such assumptions is based on information available to the
auditor at the time of the audit and the auditor is not responsible for
predicting future conditions, transactions or events which, had they been
known at the time of the audit, may have had a significant effect on
managements actions or managements assumptions underlying the fair
value measurements and disclosures. Assumptions used in fair value
measurements are similar in nature to those required when developing other
accounting estimates. ISA (UK and Ireland) 540, Audit of Accounting
Estimates provides guidance on auditing accounting estimates. This ISA
(UK and Ireland), however, addresses considerations similar to those in ISA
(UK and Ireland) 540 as well as others in the specific context of fair value
measurements and disclosures in accordance with an applicable financial
reporting framework.
6. Different financial reporting frameworks require or permit a variety of fair
value measurements and disclosures in financial statements. They also vary
in the level of guidance that they provide on the basis for measuring assets
and liabilities or the related disclosures. Some financial reporting
frameworks give prescriptive guidance, others give general guidance, and
some give no guidance at all. In addition, certain industry-specific
measurement and disclosure practices for fair values also exist. While this

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In the UK and Ireland, those charged with governance are responsible for the preparation of the
financial statements.
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ISA (UK and Ireland) provides guidance on auditing fair value
measurements and disclosures, it does not address specific types of assets or
liabilities, transactions, or industry-specific practices. The Appendix to this
ISA (UK and Ireland) discusses fair value measurements and disclosures
under different financial reporting frameworks and the prevalence of fair
value measurements, including the fact that different definitions of fair
value may exist under such frameworks. For example, International
Accounting Standard (IAS) 39, Financial Instruments: Recognition and
Measurement defines fair value as the amount for which an asset could be
exchanged, or a liability settled, between knowledgeable, willing parties in
an arms length transaction.
7. In most financial reporting frameworks, underlying the concept of fair value
measurements is a presumption that the entity is a going concern without
any intention or need to liquidate, curtail materially the scale of its
operations, or undertake a transaction on adverse terms. Therefore, in this
case, fair value would not be the amount that an entity would receive or pay
in a forced transaction, involuntary liquidation, or distress sale. An entity,
however, may need to take its current economic or operating situation into
account in determining the fair values of its assets and liabilities if
prescribed or permitted to do so by its financial reporting framework and
such framework may or may not specify how that is done. For example,
managements plan to dispose of an asset on an accelerated basis to meet
specific business objectives may be relevant to the determination of the fair
value of that asset.
8. The measurement of fair value may be relatively simple for certain assets or
liabilities, for example, assets that are bought and sold in active and open
markets that provide readily available and reliable information on the prices
at which actual exchanges occur. The measurement of fair value for other
assets or liabilities may be more complex. A specific asset may not have an
active market or may possess characteristics that make it necessary for
management to estimate its fair value (for example, an investment property
or a complex derivative financial instrument). The estimation of fair value
may be achieved through the use of a valuation model (for example, a
model premised on projections and discounting of future cash flows) or
through the assistance of an expert, such as an independent valuer.
9. The uncertainty associated with an item, or the lack of objective data may
make it incapable of reasonable estimation, in which case, the auditor
considers whether the auditors report needs modification to comply with
ISA (UK and Ireland) 700, The Auditors Report on Financial Statements.
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Understanding the Entitys Process for Determining Fair Value
Measurements and Disclosures and Relevant Control Activities,
and Assessing Risk
10. As part of the understanding of the entity and its environment,
including its internal control, the auditor should obtain an
understanding of the entitys process for determining fair value
measurements and disclosures and of the relevant control activities
sufficient to identify and assess the risks of material misstatement at
the assertion level and to design and perform further audit procedures.
11. Management
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is responsible for establishing an accounting and financial
reporting process for determining fair value measurements. In some cases,
the measurement of fair value and therefore the process set up by
management to determine fair value may be simple and reliable. For
example, management may be able to refer to published price quotations to
determine fair value for marketable securities held by the entity. Some fair
value measurements, however, are inherently more complex than others and
involve uncertainty about the occurrence of future events or their outcome,
and therefore assumptions that may involve the use of judgment need to be
made as part of the measurement process. The auditors understanding of
the measurement process, including its complexity, helps identify and
assess the risks of material misstatement in order to determine the nature,
timing and extent of the further audit procedures.
12. When obtaining an understanding of the entitys process for determining
fair value measurements and disclosures, the auditor considers, for
example:
The relevant control activities over the process used to determine fair
value measurements, including, for example, controls over data and
the segregation of duties between those committing the entity to the
underlying transactions and those responsible for undertaking the
valuations.
The expertise and experience of those persons determining the fair
value measurements.
The role that information technology has in the process.
The types of accounts or transactions requiring fair value
measurements or disclosures (for example, whether the accounts arise
from the recording of routine and recurring transactions or whether
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they arise from non-routine or unusual transactions).
The extent to which the entitys process relies on a service
organization to provide fair value measurements or the data that
supports the measurement. When an entity uses a service
organization, the auditor complies with the requirements of ISA (UK
and Ireland) 402, Audit Considerations Relating to Entities Using
Service Organizations.
The extent to which the entity uses the work of experts in determining
fair value measurements and disclosures (see paragraphs 2932 of
this Standard).
The significant management assumptions used in determining fair
value.
The documentation supporting managements assumptions.
The methods used to develop and apply management assumptions
and to monitor changes in those assumptions.
The integrity of change controls and security procedures for valuation
models and relevant information systems, including approval
processes.
The controls over the consistency, timeliness and reliability of the
data used in valuation models.
13. ISA (UK and Ireland) 315, Understanding the Entity and its Environment
and Assessing the Risks of Material Misstatement, requires the auditor to
obtain an understanding of the components of internal control. In
particular, the auditor obtains a sufficient understanding of control activities
related to the determination of the entitys fair value measurements and
disclosures in order to identify and assess the risks of material misstatement
and to design the nature, timing and extent of the further audit procedures.
14. After obtaining an understanding of the entitys process for
determining fair value measurements and disclosures, the auditor
should identify and assess the risks of material misstatement at the
assertion level related to the fair value measurements and disclosures in
the financial statements to determine the nature, timing and extent of
the further audit procedures.
15. The degree to which a fair value measurement is susceptible to
misstatement is an inherent risk. Consequently, the nature, timing and
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extent of the further audit procedures will depend upon the susceptibility to
misstatement of a fair value measurement and whether the process for
determining fair value measurements is relatively simple or complex.
15a Where the auditor has determined that the risk of material misstatement
related to a fair value measurement or disclosure is a significant risk that
requires special audit considerations, the auditor follows the requirements
of ISA (UK and Ireland) 315.
16. ISA (UK and Ireland) 315 discusses the inherent limitations of internal
controls. As fair value determinations often involve subjective judgments
by management, this may affect the nature of control activities that are
capable of being implemented. The susceptibility to misstatement of fair
value measurements also may increase as the accounting and financial
reporting requirements for fair value measurements become more complex.
The auditor considers the inherent limitations of controls in such
circumstances in assessing the risk of material misstatement.
Evaluating the Appropriateness of Fair Value Measurements
and Disclosures
17. The auditor should evaluate whether the fair value measurements and
disclosures in the financial statements are in accordance with the
entitys applicable financial reporting framework.
18. The auditors understanding of the requirements of the applicable financial
reporting framework and knowledge of the business and industry, together
with the results of other audit procedures, are used to assess whether the
accounting for assets or liabilities requiring fair value measurements is
appropriate, and whether the disclosures about the fair value measurements
and significant uncertainties related thereto are appropriate under the
entitys applicable financial reporting framework.
19. The evaluation of the appropriateness of the entitys fair value
measurements under its applicable financial reporting framework and the
evaluation of audit evidence depends, in part, on the auditors knowledge of
the nature of the business. This is particularly true where the asset or
liability or the valuation method is highly complex. For example, derivative
financial instruments may be highly complex, with a risk that differing
interpretations of how to determine fair values will result in different
conclusions. The measurement of the fair value of some items, for example
in-process research and development or intangible assets acquired in a
business combination, may involve special considerations that are affected
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by the nature of the entity and its operations if such considerations are
appropriate under the entitys applicable financial reporting framework.
Also, the auditors knowledge of the business, together with the results of
other audit procedures, may help identify assets for which management
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needs to recognize an impairment by using a fair value measurement
pursuant to the entitys applicable financial reporting framework.
20. Where the method for measuring fair value is specified by the applicable
financial reporting framework, for example, the requirement that the fair
value of a marketable security be measured using quoted market prices as
opposed to using a valuation model, the auditor considers whether the
measurement of fair value is consistent with that method.
21. Some financial reporting frameworks presume that fair value can be
measured reliably for assets or liabilities as a prerequisite to either requiring
or permitting fair value measurements or disclosures. In some cases, this
presumption may be overcome when an asset or liability does not have a
quoted market price in an active market and for which other methods of
reasonably estimating fair value are clearly inappropriate or unworkable.
When management
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has determined that it has overcome the presumption
that fair value can be reliably determined, the auditor obtains sufficient
appropriate audit evidence to support such determination, and whether the
item is properly accounted for under the applicable financial reporting
framework.
22. The auditor should obtain audit evidence about managements intent to
carry out specific courses of action, and consider its ability to do so,
where relevant to the fair value measurements and disclosures under
the entitys applicable financial reporting framework.
23. In some financial reporting frameworks, managements
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intentions with
respect to an asset or liability are criteria for determining measurement,
presentation, and disclosure requirements, and how changes in fair values
are reported within financial statements. In such financial reporting
frameworks, managements intent is important in determining the
appropriateness of the entitys use of fair value. Management often
documents plans and intentions relevant to specific assets or liabilities and
the applicable financial reporting framework may require it to do so. While
the extent of audit evidence to be obtained about managements intent is a
matter of professional judgment, the auditors procedures ordinarily include
inquiries of management, with appropriate corroboration of responses, for
example, by:
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Considering managements past history of carrying out its stated
intentions with respect to assets or liabilities.
Reviewing written plans and other documentation, including, where
applicable, budgets, minutes, etc.
Considering managements stated reasons for choosing a particular
course of action.
Considering managements ability to carry out a particular course of
action given the entitys economic circumstances, including the
implications of its contractual commitments.
The auditor also considers managements ability to pursue a specific course
of action if ability is relevant to the use, or exemption from the use, of fair
value measurement under the entitys applicable financial reporting
framework.
24. Where alternative methods for measuring fair value are available
under the entitys applicable financial reporting framework, or where
the method of measurement is not prescribed, the auditor should
evaluate whether the method of measurement is appropriate in the
circumstances under the entitys applicable financial reporting
framework.
25. Evaluating whether the method of measurement of fair value is appropriate
in the circumstances requires the use of professional judgment. When
management selects one particular valuation method from alternative
methods available under the entitys applicable financial reporting
framework, the auditor obtains an understanding of managements rationale
for its selection by discussing with management its reasons for selecting the
valuation method. The auditor considers whether:
(a) Management has sufficiently evaluated and appropriately applied the
criteria, if any, provided in the applicable financial reporting
framework to support the selected method;
(b) The valuation method is appropriate in the circumstances given the
nature of the asset or liability being valued and the entitys applicable
financial reporting framework; and
(c) The valuation method is appropriate in relation to the business,
industry and environment in which the entity operates.
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26. Management may have determined that different valuation methods result
in a range of significantly different fair value measurements. In such cases,
the auditor evaluates how the entity has investigated the reasons for these
differences in establishing its fair value measurements.
27. The auditor should evaluate whether the entitys method for its fair
value measurements is applied consistently.
28. Once management has selected a specific valuation method, the auditor
evaluates whether the entity has consistently applied that basis in its fair
value measurement, and if so, whether the consistency is appropriate
considering possible changes in the environment or circumstances affecting
the entity, or changes in the requirements of the entitys applicable financial
reporting framework. If management has changed the valuation method, the
auditor considers whether management can adequately demonstrate that the
valuation method to which it has changed provides a more appropriate basis
of measurement, or whether the change is supported by a change in the
requirements of the entitys applicable financial reporting framework or a
change in circumstances. For example, the introduction of an active market
for a particular class of asset or liability may indicate that the use of
discounted cash flows to estimate the fair value of such asset or liability is
no longer appropriate.
Using the Work of an Expert
29. The auditor should determine the need to use the work of an expert.
The auditor may have the necessary skill and knowledge to plan and
perform audit procedures related to fair values or may decide to use the
work of an expert. In making such a determination, the auditor considers
the matters discussed in paragraph 7 of ISA (UK and Ireland) 620.
30. If the use of such an expert is planned, the auditor obtains sufficient
appropriate audit evidence that such work is adequate for the purposes of
the audit, and complies with the requirements of ISA (UK and Ireland) 620.
31. When planning to use the work of an expert, the auditor considers whether
the experts understanding of the definition of fair value and the method
that the expert will use to determine fair value are consistent with that of
management and the requirements of the applicable financial reporting
framework. For example, the method used by an expert for estimating the
fair value of real estate or a complex derivative, or the actuarial
methodologies developed for making fair value estimates of insurance
obligations, reinsurance receivables and similar items, may not be
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consistent with the measurement principles of the applicable financial
reporting framework. Accordingly, the auditor considers such matters, often
by discussing, providing or reviewing instructions given to the expert or
when reading the report of the expert.
32. In accordance with ISA (UK and Ireland) 620, the auditor assesses the
appropriateness of the experts work as audit evidence. While the
reasonableness of assumptions and the appropriateness of the methods used
and their application are the responsibility of the expert, the auditor obtains
an understanding of the significant assumptions and methods used, and
considers whether they are appropriate, complete and reasonable, based on
the auditors knowledge of the business and the results of other audit
procedures. The auditor often considers these matters by discussing them
with the expert. Paragraphs 39-49 discuss the auditors evaluation of
significant assumptions used by management, including assumptions relied
upon by management based on the work of an expert.
Audit Procedures Responsive to the Risk of Material
Misstatement of the Entitys Fair Value Measurements and
Disclosures
33. The auditor should design and perform further audit procedures in
response to assessed risks of material misstatement of assertions
relating to the entitys fair value measurements and disclosures. ISA
(UK and Ireland) 330, The Auditors Procedures in Response to Assessed
Risks discusses the auditors responsibility to design and perform further
audit procedures whose nature, timing and extent are responsive to the
assessed risk of material misstatement at the assertion level. Such further
audit procedures include tests of control and substantive procedures, as
appropriate. Paragraphs 34-55 below provide additional specific guidance
on substantive procedures that may be relevant in the context of the entitys
fair value measurements and disclosures.
34. Because of the wide range of possible fair value measurements, from
relatively simple to complex, the auditors procedures can vary significantly
in nature, timing and extent. For example, substantive procedures relating to
the fair value measurements may involve (a) testing managements
significant assumptions, the valuation model, and the underlying data (see
paragraphs 3949), (b) developing independent fair value estimates to
corroborate the appropriateness of the fair value measurement (see
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paragraph 52), or (c) considering the effect of subsequent events on the fair
value measurement and disclosures (see paragraphs 5355).
35. The existence of published price quotations in an active market ordinarily is
the best audit evidence of fair value. Some fair value measurements,
however, are inherently more complex than others. This complexity arises
either because of the nature of the item being measured at fair value or
because of the valuation method required by the applicable financial
reporting framework or selected by management. For example, in the
absence of quoted prices in an active market, some financial reporting
frameworks permit an estimate of fair value based on an alternative basis
such as a discounted cash flow analysis or a comparative transaction model.
Complex fair value measurements normally are characterized by greater
uncertainty regarding the reliability of the measurement process. This
greater uncertainty may be a result of:
Length of the forecast period.
The number of significant and complex assumptions associated with
the process.
A higher degree of subjectivity associated with the assumptions and
factors used in the process.
A higher degree of uncertainty associated with the future occurrence
or outcome of events underlying the assumptions used.
Lack of objective data when highly subjective factors are used.
36. The auditors understanding of the measurement process, including its
complexity, helps guide the auditors determination of the nature, timing
and extent of audit procedures to be performed. The following are examples
of considerations in the development of audit procedures:
Using a price quotation to obtain audit evidence about valuation may
require an understanding of the circumstances in which the quotation
was developed. For example, where quoted securities are held for
investment purposes, valuation at the listed market price may require
adjustment under the entitys applicable financial reporting
framework if the holding is significantly large in size or is subject to
restrictions in marketability.
When using audit evidence provided by a third party, the auditor
considers its reliability. For example, when information is obtained
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through the use of external confirmations, the auditor considers the
respondents competence, independence, authority to respond,
knowledge of the matter being confirmed, and objectivity in order to
be satisfied with the reliability of the evidence. The extent of such
audit procedures will vary according to the assessed risk of material
misstatement associated with the fair value measurements. The
auditor complies with ISA (UK and Ireland) 505, External
Confirmations in this regard.
Audit evidence supporting fair value measurements, for example, a
valuation by an independent valuer, may be obtained at a date that
does not coincide with the date at which the entity is required to
measure and report that information in its financial statements. In
such cases, the auditor obtains audit evidence that management has
taken into account the effect of events, transactions and changes in
circumstances occurring between the date of fair value measurement
and the reporting date.
Collateral often is assigned for certain types of investments in debt
instruments that either are required to be measured at fair value or are
evaluated for possible impairment. If the collateral is an important
factor in measuring the fair value of the investment or evaluating its
carrying amount, the auditor obtains sufficient appropriate audit
evidence regarding the existence, value, rights and access to or
transferability of such collateral, including consideration whether all
appropriate liens have been filed, and considers whether appropriate
disclosures about the collateral have been made under the entitys
applicable financial reporting framework.
In some situations, additional audit procedures, such as the inspection
of an asset by the auditor, may be necessary to obtain sufficient
appropriate audit evidence about the appropriateness of a fair value
measurement. For example, inspection of an investment property may
be necessary to obtain information about the current physical
condition of the asset relevant to its fair value, or inspection of a
security may reveal a restriction on its marketability that may affect
its value.
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Testing Managements Significant Assumptions, the Valuation Model, and
the Underlying Data
37. The auditors understanding of the reliability of the process used by
management to determine fair value is an important element in support of
the resulting amounts and therefore affects the nature, timing, and extent of
further audit procedures. A reliable process for determining fair value is one
that results in reasonably consistent measurement and, where relevant,
presentation and disclosure of fair value when used in similar
circumstances. When obtaining audit evidence about the entitys fair value
measurements and disclosures, the auditor evaluates whether:
(a) The assumptions used by management are reasonable;
(b) The fair value measurement was determined using an appropriate
model, if applicable;
(c) Management used relevant information that was reasonably available
at the time.
38. Estimation techniques and assumptions and the auditors consideration and
comparison of fair value measurements determined in prior periods, if any,
to results obtained in the current period may provide audit evidence of the
reliability of managements processes. However, the auditor also considers
whether such variances result from changes in economic circumstances.
39. Where the auditor determines there is a significant risk related to fair
value, or where otherwise applicable, the auditor should evaluate
whether the significant assumptions used by management
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in
measuring fair values, taken individually and as a whole, provide a
reasonable basis for the fair value measurements and disclosures in the
entitys financial statements.
40. It is necessary for management to make assumptions, including
assumptions relied upon by management based upon the work of an expert,
to develop fair value measurements. For these purposes, managements
assumptions also include those assumptions developed under the guidance
of those charged with governance. Assumptions are integral components of
more complex valuation methods, for example valuation methods that
employ a combination of estimates of expected future cash flows together
with estimates of the values of assets or liabilities in the future, discounted
to the present. Auditors pay particular attention to the significant
assumptions underlying a valuation method and evaluate whether such
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assumptions are reasonable. To provide a reasonable basis for the fair value
measurements and disclosures, assumptions need to be relevant, reliable,
neutral, understandable and complete. Paragraph 36 of the International
Framework for Assurance Engagements describes these characteristics in
more detail.]
41. Specific assumptions will vary with the characteristics of the asset or
liability being valued and the valuation method used (e.g., replacement cost,
market or an income-based approach). For example, where discounted cash
flows (an income-based approach) are used as the valuation method, there
will be assumptions about the level of cash flows, the period of time used in
the analysis, and the discount rate.
42. Assumptions ordinarily are supported by differing types of audit evidence
from internal and external sources that provide objective support for the
assumptions used. The auditor assesses the source and reliability of audit
evidence supporting managements assumptions, including consideration of
the assumptions in light of historical information and an evaluation of
whether they are based on plans that are within the entitys capacity.
43. Audit procedures dealing with managements assumptions are performed in
the context of the audit of the entitys financial statements. The objective of
the audit procedures is therefore not intended to obtain sufficient
appropriate audit evidence to provide an opinion on the assumptions
themselves. Rather, the auditor performs audit procedures to consider
whether the assumptions provide a reasonable basis in measuring fair
values in the context of an audit of the financial statements taken as a
whole.
44. Identifying those assumptions that appear to be significant to the fair value
measurement requires the exercise of judgment by management. The
auditor focuses attention on significant assumptions. Generally, significant
assumptions cover matters that materially affect the fair value measurement
and may include those that are:
(a) Sensitive to variation or uncertainty in amount or nature. For
example, assumptions about short-term interest rates may be less
susceptible to significant variation compared to assumptions about
long-term interest rates;
(b) Susceptible to misapplication or bias.
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45. The auditor considers the sensitivity of the valuation to changes in
significant assumptions, including market conditions that may affect the
value. Where applicable, the auditor encourages management to use such
techniques as sensitivity analysis to help identify particularly sensitive
assumptions. In the absence of such management analysis, the auditor
considers whether to employ such techniques. The auditor also considers
whether the uncertainty associated with a fair value measurement, or the
lack of objective data may make it incapable of reasonable estimation under
the entitys applicable financial reporting framework (see paragraph 9).
46. The consideration of whether the assumptions provide a reasonable basis
for the fair value measurements relates to the whole set of assumptions as
well as to each assumption individually. Assumptions are frequently
interdependent, and therefore, need to be internally consistent. A particular
assumption that may appear reasonable when taken in isolation may not be
reasonable when used in conjunction with other assumptions. The auditor
considers whether management has identified the significant assumptions
and factors influencing the measurement of fair value.
47. The assumptions on which the fair value measurements are based (for
example, the discount rate used in calculating the present value of future
cash flows) ordinarily will reflect what management expects will be the
outcome of specific objectives and strategies. To be reasonable, such
assumptions, individually and taken as a whole, also need to be realistic and
consistent with:
(a) The general economic environment and the entitys economic
circumstances;
(b) The plans of the entity;
(c) Assumptions made in prior periods, if appropriate
(d) Past experience of, or previous conditions experienced by, the entity
to the extent currently applicable;
(e) Other matters relating to the financial statements, for example,
assumptions used by management in accounting estimates for
financial statement accounts other than those relating to fair value
measurements and disclosures; and
(f) If applicable, the risk associated with cash flows, including the
potential variability of the cash flows and the related effect on the
discounted rate.
18
Where assumptions are reflective of managements intent and ability to
carry out specific courses of action, the auditor considers whether they are
consistent with the entitys plans and past experience (see paragraphs 22
and 23).
48. If management relies on historical financial information in the development
of assumptions, the auditor considers the extent to which such reliance is
justified. However, historical information might not be representative of
future conditions or events, for example, if management intends to engage
in new activities or circumstances change.
49. For items valued by the entity using a valuation model, the auditor is not
expected to substitute his or her judgment for that of the entitys
management. Rather, the auditor reviews the model, and evaluates whether
the model is appropriate and the assumptions used are reasonable. For
example, it may be inappropriate to use a discounted cash flow method in
valuing an equity investment in a start-up enterprise if there are no current
revenues on which to base the forecast of future earnings or cash flows.
50. The auditor should perform audit procedures on the data used to
develop the fair value measurements and disclosures and evaluate
whether the fair value measurements have been properly determined
from such data and managements assumptions.
51. The auditor evaluates whether the data on which the fair value
measurements are based, including the data used in the work of an expert,
are accurate, complete and relevant; and whether the fair value
measurements have been properly determined using such data and
managements assumptions. The auditors procedures also may include, for
example, audit procedures such as verifying the source of the data,
mathematical recalculation and reviewing of information for internal
consistency, including whether such information is consistent with
managements intent to carry out specific courses of action discussed in
paragraphs 22 and 23.
Developing Independent Fair Value Estimates for Corroborative Purposes
52. The auditor may make an independent estimate of fair value (for example,
by using an auditor-developed model) to corroborate the entitys fair value
measurement. When developing an independent estimate using
managements assumptions, the auditor evaluates those assumptions as
discussed in paragraphs 39-49. Instead of using managements assumptions
19
the auditor may develop separate assumptions to make a comparison with
managements fair value measurements. In that situation, the auditor
nevertheless understands managements assumptions. The auditor uses that
understanding to determine that the auditors model considers the
significant variables and to evaluate any significant difference from
managements estimate. The auditor also performs audit procedures on the
data used to develop the fair value measurements and disclosures as
discussed in paragraphs 50 and 51. The auditor considers the guidance
contained in ISA (UK and Ireland) 520, Analytical Procedures when
performing these procedures during an audit.
Subsequent Events
53. The auditor should consider the effect of subsequent events on the fair
value measurements and disclosures in the financial statements.
54. Transactions and events that occur after period-end but prior to completion
of the audit, may provide appropriate audit evidence regarding the fair
value measurements made by management. For example, a sale of
investment property shortly after the period-end may provide audit evidence
relating to the fair value measurement.
55. In the period after a financial statement period-end, however, circumstances
may change from those existing at the period-end. Fair value information
after the period -end may reflect events occurring after the period-end and
not the circumstances existing at the balance sheet date. For example, the
prices of actively traded marketable securities that change after the period-
end ordinarily do not constitute appropriate audit evidence of the values of
the securities that existed at the period-end. The auditor complies with ISA
(UK and Ireland) 560, Subsequent Events when evaluating audit evidence
relating to such events.
Disclosures About Fair Values
56. The auditor should evaluate whether the disclosures about fair values
made by the entity are in accordance with its financial reporting
framework.
57. Disclosure of fair value information is an important aspect of financial
statements in many financial reporting frameworks. Often, fair value
disclosure is required because of the relevance to users in the evaluation of
an entitys performance and financial position. In addition to the fair value
information required by the applicable financial reporting framework, some
20
entities disclose voluntary additional fair value information in the notes to
the financial statements.
58. When auditing fair value measurements and related disclosures included in
the notes to the financial statements, whether required by the applicable
financial reporting framework or disclosed voluntarily, the auditor
ordinarily performs essentially the same types of audit procedures as those
employed in auditing a fair value measurement recognized in the financial
statements. The auditor obtains sufficient appropriate audit evidence that
the valuation principles are appropriate under the entitys applicable
financial reporting framework, are being consistently applied, and the
method of estimation and significant assumptions used are properly
disclosed in accordance with the entitys applicable financial reporting
framework. The auditor also considers whether voluntary information may
be inappropriate in the context of the financial statements. For example,
management
1
may disclose a current sales value for an asset without
mentioning that significant restrictions under contractual arrangements
preclude the sale in the immediate future.
59. The auditor evaluates whether the entity has made appropriate disclosures
about fair value information as called for by its financial reporting
framework. If an item contains a high degree of measurement uncertainty,
the auditor assesses whether the disclosures are sufficient to inform users of
such uncertainty. For example, the auditor might evaluate whether
disclosures about a range of amounts, and the assumptions used in
determining the range, within which the fair value is reasonably believed to
lie is appropriate under the entitys applicable financial reporting
framework, when management
1
considers a single amount presentation not
appropriate. Where applicable, the auditor also considers whether the entity
has complied with the accounting and disclosure requirements relating to
changes in the valuation method used to determine fair value
measurements.
60. When disclosure of fair value information under the applicable financial
reporting framework is omitted because it is not practicable to determine
fair value with sufficient reliability, the auditor evaluates the adequacy of
disclosures required in these circumstances. If the entity has not
appropriately disclosed fair value information required by the applicable
financial reporting framework, the auditor evaluates whether the financial
statements are materially misstated by the departure from the applicable
financial reporting framework.
21
Evaluating the Results of Audit Procedures
61. In making a final assessment of whether the fair value measurements
and disclosures in the financial statements are in accordance with the
entitys applicable financial reporting framework, the auditor should
evaluate the sufficiency and appropriateness of the audit evidence
obtained as well as the consistency of that evidence with other audit
evidence obtained and evaluated during the audit.
62. When assessing whether the fair value measurements and disclosures in the
financial statements are in accordance with the entitys applicable financial
reporting framework, the auditor evaluates the consistency of the
information and audit evidence obtained during the audit of fair value
measurements with other audit evidence obtained during the audit, in the
context of the financial statements taken as a whole. For example, the
auditor considers whether there is or should be a relationship or correlation
between the interest rates used to discount estimated future cash flows in
determining the fair value of an investment property and interest rates on
borrowings currently being incurred by the entity to acquire investment
property.
Management Representations
63. The auditor should obtain written representations from management
regarding the reasonableness of significant assumptions, including
whether they appropriately reflect managements intent and ability to
carry out specific courses of action on behalf of the entity where
relevant to the fair value measurements or disclosures.
64. ISA (UK and Ireland) 580, Management Representations discusses the
use of management representations as audit evidence. Depending on the
nature, materiality and complexity of fair values, management
3

representations about fair value measurements and disclosures contained in
the financial statements also may include representations about:
The appropriateness of the measurement methods, including related
assumptions, used by management in determining fair values within
the applicable financial reporting framework, and the consistency in
application of the methods.
The basis used by management to overcome the presumption relating
to the use of fair value set forth under the entitys applicable financial
reporting framework.
22
The completeness and appropriateness of disclosures related to fair
values under the entitys applicable financial reporting framework.
Whether subsequent events require adjustment to the fair value
measurements and disclosures included in the financial statements.
Communication with Those Charged with Governance
65. ISA (UK and Ireland) 260, Communication of Audit Matters with Those
Charged with Governance requires auditors to communicate audit matters
of governance interest with those charged with governance. Because of the
uncertainties often involved with some fair value measurements, the
potential effect on the financial statements of any significant risks may be
of governance interest. For example, the auditor considers communicating
the nature of significant assumptions used in fair value measurements, the
degree of subjectivity involved in the development of the assumptions, and
the relative materiality of the items being measured at fair value to the
financial statements as a whole. The auditor considers the guidance
contained in ISA (UK and Ireland) 260 when determining the nature and
form of communication.
Effective Date
66. This ISA (UK and Ireland) is effective for audits of financial statements for
periods commencing on or after 15 December 2004.
Public Sector Perspective
Additional guidance for auditors of public sector bodies in the UK and
Ireland is given in:
Practice Note 10 Audit of Financial Statements of Public Sector
Entities in the United Kingdom (Revised)
Practice Note 10(I) The Audit of Central Government Financial
Statements in Ireland
1. Many governments are moving to accrual accounting and are adopting fair
value as the basis of valuation for many classes of the assets and liabilities
that they hold, or for disclosures of items in the financial statements. The
broad principles of this ISA (UK and Ireland) are therefore applicable to
the consideration of the audit of fair value measurements and disclosures
included in the financial statements of public sector entities.
23
2. Paragraph 3 of the ISA (UK and Ireland) states that when fair value
measurements and disclosures are material to the financial statements, the
auditor should obtain sufficient appropriate audit evidence that such
measurements and disclosures are in accordance with the entitys
applicable financial reporting framework. The International Public Sector
Accounting Standards accounting framework include a number of standards
that require or allow the recognition or disclosure of fair values.
3. As noted in paragraph 8 of the ISA (UK and Ireland), determining the fair
value of certain assets or liabilities may be complex where there is no active
market. This can be a particular issue in the Public Sector, where entities
have significant holdings of specialized assets. Furthermore many assets
held by public sector entities do not generate cash flows. In these
circumstances a fair value or similar current value may be estimated by
reference to other valuation methods including, but not limited to,
depreciated replacement cost and indexed price method.
24
Appendix
Fair Value Measurements and Disclosures under Different
Financial Reporting Frameworks
1. Different financial reporting frameworks require or permit a variety of fair
value measurements and disclosures in financial statements. They also vary
in the level of guidance that they provide on the basis for measuring assets
and liabilities or the related disclosures. Some financial reporting
frameworks give prescriptive guidance, others give general guidance, and
some give no guidance at all. In addition, certain industry-specific
measurement and disclosure practices for fair values also exist.
2. Different definitions of fair value may exist among financial reporting
frameworks, or for different assets, liabilities or disclosures within a
particular framework. For example, International Accounting Standard
(IAS) 39, Financial Instruments: Recognition and Measurement defines
fair value as the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arms length
transaction. The concept of fair value ordinarily assumes a current
transaction, rather than settlement at some past or future date. Accordingly,
the process of measuring fair value would be a search for the estimated
price at which that transaction would occur. Additionally, different financial
reporting frameworks may use such terms as entity-specific value, value
in use, or similar terms, but may still fall within the concept of fair value
in this ISA (UK and Ireland).
3. Different financial reporting frameworks may treat changes in fair value
measurements that occur over time in different ways. For example, a
particular financial reporting framework may require that changes in fair
value measurements of certain assets or liabilities be reflected directly in
equity, while such changes might be reflected in income under another
framework. In some frameworks, the determination of whether to use fair
value accounting or how it is applied is influenced by managements intent
to carry out certain courses of action with respect to the specific asset or
liability.
4. Different financial reporting frameworks may require certain specific fair
value measurements and disclosures in financial statements and prescribe or
permit them in varying degrees. The financial reporting frameworks may:
25
Prescribe measurement, presentation and disclosure requirements for
certain information included in the financial statements or for
information disclosed in notes to financial statements or presented as
supplementary information.
Permit certain measurements using fair values at the option of an
entity or only when certain criteria have been met.
Prescribe a specific method for determining fair value, for example,
through the use of an independent appraisal or specified ways of
using discounted cash flows.
Permit a choice of method for determining fair value from among
several alternative methods (the criteria for selection may or may not
be provided by the financial reporting framework).
Provide no guidance on the fair value measurements or disclosures of
fair value other than their use being evident through custom or
practice, for example, an industry practice.
5. Some financial reporting frameworks presume that fair value can be
measured reliably for assets or liabilities as a prerequisite to either requiring
or permitting fair value measurements or disclosures. In some cases, this
presumption may be overcome when an asset or liability does not have a
quoted market price in an active market and for which other methods of
reasonably estimating fair value are clearly inappropriate or unworkable.
6. Some financial reporting frameworks require certain specified adjustments
or modifications to valuation information, or other considerations unique to
a particular asset or liability. For example, accounting for investment
properties may require adjustments to be made to an appraised market
value, such as adjustments for estimated closing costs on sale, adjustments
related to the propertys condition and location, and other matters.
Similarly, if the market for a particular asset is not an active market,
published price quotations may have to be adjusted or modified to arrive at
a more suitable measure of fair value. For example, quoted market prices
may not be indicative of fair value if there is infrequent activity in the
market, the market is not well established, or small volumes of units are
traded relative to the aggregate number of trading units in existence.
Accordingly, such market prices may have to be adjusted or modified.
Alternative sources of market information may be needed to make such
adjustments or modifications.
26
Prevalence of Fair Value Measurements
7. Measurements and disclosures based on fair value are becoming
increasingly prevalent in financial reporting frameworks. Fair values may
occur in, and affect the determination of, financial statements in a number
of ways, including the measurement at fair value of:
Specific assets or liabilities, such as marketable securities or
liabilities to settle an obligation under a financial instrument,
routinely or periodically marked-to-market.
Specific components of equity, for example when accounting for the
recognition, measurement and presentation of certain financial
instruments with equity features, such as a bond convertible by the
holder into common shares of the issuer.
Specific assets or liabilities acquired in a business combination. For
example, the initial determination of goodwill arising on the purchase
of an entity in a business combination usually is based on the fair
value measurement of the identifiable assets and liabilities acquired
and the fair value of the consideration given.
Specific assets or liabilities adjusted to fair value on a one-time basis.
Some financial reporting frameworks may require the use of a fair
value measurement to quantify an adjustment to an asset or a group of
assets as part of an asset impairment determination, for example, a
test of impairment of goodwill acquired in a business combination
based on the fair value of a defined operating entity or reporting unit,
the value of which is then allocated among the entitys or units group
of assets and liabilities in order to derive an implied goodwill for
comparison to the recorded goodwill.
Aggregations of assets and liabilities. In some circumstances, the
measurement of a class or group of assets or liabilities calls for an
aggregation of fair values of some of the individual assets or
liabilities in such class or group. For example, under an entitys
applicable financial reporting framework, the measurement of a
diversified loan portfolio might be determined based on the fair value
of some categories of loans comprising the portfolio.
Transactions involving the exchange of assets between independent
parties without monetary consideration. For example, a non-monetary
exchange of plant facilities in different lines of business.
27
Information disclosed in notes to financial statements or presented as
supplementary information, but not recognized in the financial
statements.

28
NOTICE TO READERS

The Auditing Practices Board Limited

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The ISAs (UK and Ireland) are based on International Standards on Auditing of the
same titles, which have been issued by the International Auditing and Assurance
Standards Board and published by the International Federation of Accountants.

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